The Federal Reserve Bank of New York works to promote sound and well-functioning financial systems and markets through its provision of industry and payment services, advancement of infrastructure reform in key markets and training and educational support to international institutions.

The Outreach & Education function engages, empowers and educates the public in the Second District. Our outreach mission furthers the Bank’s commitment to the region by listening to the communities we serve and developing programs, analysis and sponsored conferences and clinics to help meet their needs. Our education mission aims to advance public knowledge about the Federal Reserve System and its role in the economy.

Remarks at the Federal Reserve Bank of New York Inflation-Indexed Securities and Inflation Risk Management Conference

Welcome to the New York Fed and to this timely conference on inflation-indexed
securities and inflation risk management. Before discussing "The
Case for TIPS," I would like to thank conference organizers, participants,
panelists and supporting Bank staff for planning and putting together today's
event.

In particular, I wanted to thank John Campbell for his contribution to making
today's conference a reality and I expect that his involvement will heighten
attention to this subject and stimulate additional research from the
academic community on the topics we discuss here.

Over the past year, Treasury has been evaluating the costs and benefits of
the TIPS program. Some research studies on this topic have concluded
that the incremental financing costs associated with the TIPS program have
been substantial; leading some to conclude that the costs may outweigh the
benefits. Today’s program, which includes a panel discussion on
the welfare benefits of inflation-protected securities, should help to broaden
our knowledge on this topic.

As the title of my speech suggests, today I am
going to lay out the reasons why I, along with my colleagues Jennifer Roush
and Michelle Steinberg Ezer, believe that the benefits of the TIPS program
exceed the costs of the program.

Before saying anything more, let me emphasize
that the views I express today are my own and those of my co-authors and, therefore,
may not represent the views of my colleagues on the Federal Open Market Committee.
Also, let me note that Jennifer and Michelle are the main authors of this paper.
I have ridden along on their coattails. My main contribution was to slow
down completion as I had to fit in my very modest contributions around the
unfolding financial crisis! Finally, you may be wondering
why this is my first speech since I have become president—an odd subject
to choose, perhaps, given the ongoing financial crisis? The answer
is a simple one, our paper and this conference have been in train for a long
time. It is just a coincidence that the conference and my becoming president
of the New York Fed have happened to arrive at about the same time.

The logic of issuing
inflation-protected securities is straightforward. Wouldn’t
some investors pay a premium—that is, accept a lower expected return—in
exchange for guaranteed, full compensation for inflation? Because the United
States and a number of other countries decided that the answer was likely to
be “yes,” they developed an inflation-indexed government debt
market.

Has the program been a good development from the perspective of the
U.S. Treasury? What about from the public’s perspective?

A good starting
point for answering these questions is to account for the costs and benefits
of the program relative to an appropriate counterfactual. For example, we might
start by comparing the difference in funding costs to the Treasury of TIPS
versus a program of comparable duration nominal Treasuries.

But we should also
be careful not to ignore other potential benefits of the TIPS program. As we
see it, these potential benefits include:

the provision of a virtually risk-free investment that provides value to
risk-averse investors,

access to a market-determined measure of inflation expectations that can
help inform the conduct of monetary policy,

greater diversification of the Treasury’s funding sources, which
presumably has favorable implications for the Treasury’s overall funding
costs, and

the potential for TIPS issuance to reduce the variability of the U.S. government’s
net financial position and provide an explicit incentive for the fiscal authorities
to conduct policy with an eye toward the consequences of inflation.

Although it is difficult to quantify these benefits, we argue that they are
meaningful and should not be ignored in evaluating the benefits of the TIPS
program.

Turning first to the issue of measuring the impact of TIPS issuance
on the government’s funding costs, this could be done simply by comparing
the ex-post costs
of a program of TIPS issuance to the costs of a comparable program of nominal
Treasury issuance. Studies1 of
this sort have typically shown that TIPS issuance has resulted in a higher
net cost to the Treasury. Unfortunately, although this methodology is attractive
in its simplicity, it has some flaws that undercut its usefulness in reaching
conclusions about the attractiveness of the TIPS program.

The problem with
an ex-post analysis is that it depends critically
upon the performance of inflation over the period in question. If inflation
turns out to have been meaningfully different than what was expected at the
time of TIPS issuance, then this difference—the so-called “inflation
surprise”—can be important in affecting the relative costs of TIPS
versus nominal Treasury issuance. If inflation turns out to be higher than
expected, then TIPS issuance will likely look to have been more expensive than
nominal Treasury issuance. If inflation turns out lower, an ex-post analysis
will likely show a savings from the TIPS program.

Over the long run—and
I mean the very long run—there should
be roughly as many downward surprises in inflation performance as upward surprises.
But within any relatively short period, such as the last decade, this certainly
does not need to be the case. In other words, over such a short period, the
outcome of an ex-post analysis can be heavily influenced by which
of the two sides—the Treasury or investors—was the lucky recipient
of the net inflation surprise that occurred over the period in question. For
example, in countries such as the United Kingdom, where inflation declined
following the inception of an inflation-linked debt program, ex-post studies
generally suggest that these programs have reduced financing costs for these
countries.

The fact that the Treasury saved or lost money ex-post is
thus not a very reliable guide as to whether the strategic decision to implement
a TIPS program has been a good idea. The relevant question is whether the Treasury
obtained the financing it needed at a lower ex-ante cost. If the
experiment were to be run thousands of times drawing from the underlying distribution
of possible inflation outcomes, would Treasury’s costs have been lower,
on average, with TIPS or with nominal Treasuries? To conclude on the basis
of one coin flip or roll of the dice as ex-post analysis essentially
does surely is not the best way to evaluate the respective costs of TIPS issuance
versus nominal Treasuries.

Thus, we need to focus on the underlying factors
that determine the ex-ante difference in costs.

There are two primary factors2 underlying
the relative cost differences:

1) the compensation investors require to hold
a security that is less liquid than its nominal counterpart, termed the illiquidity
premium, and 2) the insurance value they attach to obtaining protection against
inflation risk, known as the inflation risk premium.

With regard to the first factor, when investors
are worried about their ability to resell TIPS in a liquid secondary market,
they require compensation for holding the securities compared with more liquid
alternatives. This illiquidity premium tends to drive up TIPS yields and increase
the Treasury’s borrowing
costs.

The second factor works in the opposite direction. To the extent that
investors are willing to pay for inflation protection, they would purchase
TIPS at a price above that implied by their expected payment stream. As
such, inflation risk premiums result in lower expected borrowing costs for
the government and savings for the TIPS program compared with nominal issuance.

To
determine which factor has been historically dominant, we conduct an ex-ante cost
analysis: We compare the amount that the Treasury received for inflation compensation
at auction with an observable measure of the inflation expectations of TIPS
investors that is not contaminated by premiums for inflation risk or liquidity
differentials. Unfortunately, we don’t have a perfect measure of expected
inflation. Nevertheless, we may be able to get close. We do have estimates
of expected inflation from other sources—such as the Survey of Professional
Forecasters (SPF) conducted by the Federal Reserve Bank of Philadelphia. If
such measures do indeed reflect the inflation expectations of investors, then
we can conduct a reasonably accurate ex-ante analysis.

TIPS analysts often talk about a concept they call the breakeven inflation
rate. Essentially, this is the realized inflation rate that would cause investors
to come out the same in terms of total compensation regardless of whether they
had bought TIPS or nominal Treasuries.

The difference between the auction breakeven
inflation rate and the SPF forecast yields a measure of the net savings or
loss incurred by the Treasury that is independent of forecast errors. It is
also equal to the net value of the illiquidity and inflation risk premiums
associated with each TIPS. Our analysis, which covers TIPS auctions through
April 2008, found that prior to 2004, the breakeven inflation rate was below
the SPF. This indicates that the illiquidity premiums exceeded the inflation
risk premium over this period. However, since 2004, we find that breakeven
inflation rates were approximately equal to expected inflation, indicating
that investors were roughly indifferent between the benefit of being protected
against inflation risk versus the cost in terms of the greater illiquidity
of TIPS relative to on-the-run nominal Treasuries. Thus, on an ex-ante basis,
it appeared that the cost of issuing TIPS was about equal to the cost of issuing
nominal Treasuries.

To determine the impact of the illiquidity premium and
inflation risk premium on these results, we decomposed our ex-ante analysis,
comparing the breakeven rate of inflation excluding the illiquidity premium
in TIPS yields3 to
the SPF forecast. This comparison yields an estimate of the premium investors
were willing to pay for inflation protection at previous TIPS auctions. We
found an average risk premium estimate of 47 basis points over our sample period.
This suggests that the TIPS program does satisfy a real demand that is not
met by nominal Treasuries.

It also suggests that if the Treasury were to take steps to shrink the illiquidity
premium by, for example, improving secondary market trading in TIPS, this would
shift the cost-benefit analysis more firmly in TIPS direction.

A change in
the TIPS illiquidity premium can have a notable impact on ex-ante cost
analysis. For example, at the time this speech was written, the 10-year
TIPS breakeven rate was approximately 1.10 percent, compared to the SPF forecast
of 2.50 percent. This is in contrast to the end of our sample period,
which showed them to be about equal. This means that today TIPS issuance
is not very compelling. But it is important to emphasize that this shift has
occurred at a time when the preference for liquidity is especially strong,
benefitting nominal Treasuries versus TIPS. When the market turmoil subsides
and this illiquidity premium shrinks, one might expect TIPS to again move ahead
on an ex-ante basis.

So, at this point, the TIPS versus nominal issuance
debate is inconclusive. But that’s before we have included some of the
other considerable—although
more difficult to quantify—benefits associated with TIPS issuance.

Let
me now discuss some of these other benefits.

Inflation Hedge for HouseholdsFirst, TIPS offer a benefit to investors
because they have less risk than any other asset class. With virtually no credit
risk or inflation risk, TIPS are one of the safest of investments.4 For
investors that want such safety, TIPS offer significant benefits. Furthermore,
the ability for investors to choose the amount of inflation risk they hold
may result in a more optimal allocation of risk among investors with different
tolerances.5 How much is
this worth? Is the value of this completely captured in the relative interest
costs of TIPS? Probably not, because the relative interest costs between TIPS
and nominal Treasuries are set at the margin. We think there is some value
in having a high-quality hedge to inflation risk, especially one that is available
to less sophisticated investors.

Improved Monetary Policy
The second noteworthy benefit from the TIPS program is that it helps improve
the conduct of monetary policy. Foremost, the program provides up-to-date
information about the evolution of inflation expectations and real interest
rates. Because keeping inflation expectations well-anchored is so important
in keeping inflation itself in check, real-time measures of inflation expectations
may lead to better monetary policymaking. This, in turn, should improve macroeconomic
performance. Although this is very difficult to quantify in terms of value,
I think it is safe to say that in a $14 trillion economy, even a modest improvement
in performance generates large dollar benefits.

U.S. policymakers focus on a variety of inflation expectation measures, including
private surveys of inflation expectations and market based measures, such as
TIPS breakeven inflation rates. But in practice, the value of the survey-based
measures is limited by the lack of timeliness—new data become available
only monthly, quarterly or about every six weeks. Also, real money isn’t
riding on the accuracy of the survey responses. In contrast, the comparison
between nominal Treasury and TIPS yields represents the consensus of market
participants.

For these reasons, policymakers rely importantly on the long-term inflation
expectations proxied by the difference between nominal Treasury note and TIPS
yields.

So, how much is this tool worth? Of course, it is very difficult to
say. Perhaps, we would flatter ourselves and think that we could do just as
well without such a market-based, real-time measure of inflation expectations.
But I doubt it. After all, inflation expectations, when untethered, are very
difficult to re-anchor. TIPS help make it easier to keep inflation expectations
in check.

Improved Fiscal Policy
The third less quantifiable benefit of TIPS is that the program may create
incentives that can improve the conduct of fiscal policy. TIPS provide
an explicit incentive for the fiscal authorities to conduct policy with an
eye toward the consequences for inflation. The public’s recognition
of this incentive may help hold down inflation expectations and cause inflation
expectations to be more firmly anchored.

In addition, TIPS may give the Treasury
access to a broader investor base, which also may reduce the Treasury’s
overall borrowing costs. The comparison between the prevailing interest rates
on TIPS versus nominal Treasuries provides insight into the relative costs
associated with issuing a marginal dollar of debt. But just as important is
whether TIPS issuance, by displacing nominal Treasury issuance, reduces the
level of interest rates that the Treasury pays on its nominal issuances. This
would occur if TIPS were not perfect substitutes for nominal Treasury securities
and if the demand for nominal Treasuries were downward sloping— that
is, not completely elastic.

The first condition almost certainly holds given the different attributes
of TIPS versus nominal Treasuries. If they were perfect substitutes, then there
would not be a liquidity premium for nominal Treasuries relative to TIPS. The
second condition seems likely to hold since numerous studies have found that
an increase in the net amount of Treasury borrowing leads to higher expected
borrowing costs for the Treasury.

How big might this effect be? That’s
difficult to estimate. A few studies6 have
found that an increase in supply in a particular segment of the Treasury yield
curve has contributed to a rise in yields. As a result, by issuing securities
in a segmented TIPS market, the Treasury may keep realized yields on bill and
nominal coupon securities lower than they otherwise would have been.

The last
noteworthy fiscal benefit from TIPS issuance is the fact that it reduces risk
to the U.S. government in terms of the variability of its net financial position.
The rate of inflation influences both the cost of TIPS and the government’s
tax receipts. Thus, some level of TIPS issuance may reduce the variability
of the government’s net financial position. This, in turn, should lead
to a more regular and predictable pattern of issuance, which should help minimize
interest costs.

In summary, our analysis of the ex-ante costs of the TIPS program
and the more difficult-to-measure benefits suggests that TIPS issuance provides
at least a modest net benefit to the Treasury. So, now I want to turn to a
related question: Are there ways to increase the benefits?

I would be willing
to make two modest suggestions here. First, it may make sense to emphasize
longer-dated TIPS issuance rather than shorter-dated issuance. Analytically,
the logic goes as follows. Inflation uncertainty is likely to increase at longer
time horizons. Thus, investors are likely to pay a greater premium for inflation
protection at longer-time horizons. This implies that the cost savings associated
with TIPS are likely to be greater for longer maturities rather than shorter
maturities.

This prediction is supported by empirical studies that have examined
the premium that investors pay for inflation protection both in the United
States and elsewhere. For example, a study by Brian Sack of Macroeconomic Advisors
finds that forward breakeven inflation rates increase as maturity lengthens.
In contrast, the level of survey-based measures of inflation expectations is
quite constant beyond a time horizon of a few years. This means that the difference
between forward breakeven inflation and inflation expectations climbs as the
time horizon extends. This strongly suggests that the premium investors pay
for inflation protection increases as maturities lengthen.

Second, it may make
sense to structure the TIPS program in a way that would help reduce the illiquidity
premium associated with TIPS relative to on-the-run nominal Treasuries. Some
of the current illiquidity premium is likely to shrink as financial markets
stabilize. However, further improvements may require a change in either the
structure of the TIPS program or the secondary market trading environment.

On that note, I leave you with two outstanding questions:

1.What are the best
ways for the U.S. Treasury and the trading community to improve secondary market
liquidity in TIPS?
2. Given that TIPS appear attractive for the U.S. Treasury,
what is the optimal allocation of the Treasury’s liability portfolio
between TIPS and nominal securities?

Thank you for your attention.

__________________________________________

1 See Sack and Elsasser
(2004), Roush (2008).2 In addition to these primary
factors, TIPS yields also reflect the taxation difference between TIPS
and nominal issues, the convexity difference between real and nominal yields
and the price of the embedded deflation floor.3 We used the illiquidity
premium in TIPS yields estimated in D’Amico, Kim and Wei (2008).
D’Amico,
Kim and Wei calculated the liquidity component for five- and ten-year TIPS
yields, which we used to adjust the auction prices for 5- and 10-year TIPS
issues. For twenty- and thirty-year TIPS issues, we assumed that
the liquidity component is equal to the component for a ten-year security,
which in the event that these securities are less liquid than the ten-year
note, understates this effect and thus underestimates the risk premium
at this horizon. For further information, see Dudley, Roush and
Steinberg Ezer (2008).4 There is some inflation
basis risk in that TIPS are based on the non-seasonally-adjusted consumer
price index, and a household’s expenditure basket might differ from
the basket in the CPI. Also, pension and endowment liabilities may
be more closely related to other inflation or wage measures than the CPI.5 See Campbell and Shiller, 1996.6 See Fleming (2002), Krishnamurthy
(2002), Laubach (2003).